A welcome announcement in the May 2010 Federal Budget was that the tax treatment of earnouts is to be addressed. There has been much uncertainty in this area following the release of a draft taxation ruling, TR 2007/D10, in October 2007 which had attracted criticism and was never finalised.
The draft taxation ruling treated an earnout right created under an arrangement to sell an income producing asset as an asset that was separate from the income producing asset being sold for capital gains tax (CGT) purposes. It was stated in the Budget Papers that the treatment in the draft ruling could result in anomalous outcomes for taxpayers where the actual payments under the earnout right differed from the amounts estimated at the start of the arrangement. The treatment in the draft ruling also gave rise to issues concerning what value should be placed on the earnout for CGT purposes.
Look-through tax treatment
The proposed change in taxation treatment is to allow all payments under a qualifying earnout arrangement to be treated as relating to the underlying business asset. This is referred to as "look-through" treatment.
Shortly after the Budget announcement, the Government released a Proposals Paper intended to form the basis for consultation on the design of the proposed tax treatment of earnouts.
The Budget announcement referred to the proposed tax treatment applying to "qualifying" earnout arrangements. It appears from the Proposals Paper that this may refer to integrity rules that will be introduced to ensure that earnout arrangements subject to the new tax rules are genuine and the new rules are not being exploited. The proposed integrity rules will include:
- a maximum time limit for the earnout (eg. five years)
- payments must be genuinely contingent and related to the performance of the asset
- the earnout right must exist due to uncertainty concerning the value of one or more of the assets the subject of the sale
- it must be an arm's length transaction, and
- it will not be available in respect of assets that are trading stock or revenue assets.
The Proposals Paper indicates that the underlying principle of the "look-through" approach to taxation is to ignore the earnout right and treat all payments as related to the sale or purchase of the original business asset. The treatment will differ depending on whether the arrangement is a standard earnout or a reverse earnout.
A standard earnout arrangement is one where an asset is sold for consideration which includes the creation of an earnout right in the seller of the asset, so that the seller will have a right to receive future amounts calculated by reference to the earnings generated by the asset for a certain period following the sale. A cost recovery method is proposed for standard earnouts and payments will be treated as related to the sale or purchase of the original asset and recognised as they become entitled to be paid. The seller will reduce its cost base in the asset the subject of the sale as and when amounts the seller is due to receive become certain. Once the seller's cost base has been reduced to zero, the seller will be treated as realising a capital gain on all further amounts received. An implication of the cost recovery method is that the seller cannot realise a capital loss until the end of the arrangement. So as far as the buyer is concerned, payments will be included in the cost base of the asset acquired for CGT purposes as and when made.
A reverse earnout arrangement is where the seller of an asset accepts a nominated sum as consideration for its sale but agrees to pay the purchaser an amount, or amounts following the sale calculated by reference to the earnings generated by the asset for a certain period following the sale, i.e. the buyer has a right to further payments depending on the earnings from the asset. A repaid method is proposed for reverse earnouts which, according to the Proposals Paper, involves extending the existing repaid and recoupment tax rules to reverse earnout payments.
Payments received by a buyer under a reverse earnout would be treated as a partial refund of the purchase price of the asset. Accordingly, the seller would reduce the capital proceeds treated as having been received from disposal of the asset as and when the seller is obligated to pay amounts to the buyer (and would need to amend their tax assessment at the end of each relevant tax year). As a corollary, the buyer would decrease their cost base in the asset for CGT purposes as and when they recoup part of the purchase price.
Application Date and Transitional Provisions
The proposed changes will apply to earnout arrangements entered into after the date of Royal Assent of legislation giving effect to the new tax treatment.
Transitional arrangements are proposed:
- taxpayers will have the choice to apply the "look-through" treatment announced in the Budget for earnout arrangements entered into between the dates of the Budget announcement and Royal Assent of enabling legislation (inclusive)
- for a standard earnout, the buyer will have the choice to apply "look-through" treatment for arrangements entered into on or after 17 October 2007 (the date of release of draft taxation ruling TR 2007/D10). For arrangements prior to that date, they have the choice to rely on Ruling TR 93/15 (which was the prior earnout ruling which was to be replaced by TR 2007/D10 – and which provided for CGT treatment of earnouts although did provide for "look-through" treatment so far as the buyer was concerned).
The closing date for submissions on the Government's Proposals Paper is 11 June 2010.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.